US companies have spent $2 trillion doing something that has absolutely no impact on their business

Sales are actually OK, and it's profitable, but the
restaurateur's backers are obsessed with profits per table. They
think raising that number would make the restaurant seem
exclusive and attractive to new investors.

But no matter how hard he tries, the restaurateur just can't get
more people in the door. So he does something else: He takes away
some tables.

It costs money to move and store the tables, but that very month,
the same number of people visit the restaurant, and profits per
table go up. Sales haven't changed, but now the investors are
happy.

If this bothers you, consider that it's exactly like something
public companies in America do every day.

That's $2.1 trillion not spent on training employees, building
new factories, or paying off borrowings. It's not even directly
being handed back to shareholders in a dividend that could be
reinvested.

But buybacks
obviously have fans, like billionaire investor Carl Icahn,
who
wrote to Apple CEO Tim Cook in 2013: "It is our belief
that a company’s board has a responsibility to recognize
opportunities to increase shareholder value, which includes
allocating capital to execute large and well-timed
buybacks."

In the same letter, Icahn
argued that if Apple repurchased the shares, "the result would be an immediate 33% boost
to earnings per share, translating into a 33% increase in the
value of the shares."

Carl
Icahn, chairman of Icahn Enterprises.Neilson Barnard/Getty Images for New York
Times

But the other view on buybacks is that — like the restaurant
removing tables — their only impact is in
making things look better than they seem. Yes, earnings per
share rise, but that's
not because earnings are growing. Even their fiercest
proponents — somewhat hypocritically — say they're overused.

Here's Icahn again, just this month, speaking on CNBC:

"I'm the first to say that there are too many buybacks, by
the way. I think that many companies are doing buybacks rather
than put money into much-needed capital improvements."

Icahn also said in the interview that he thinks one reason this
is going on is that executives are paid with stock, and they
think buybacks will boost the value of that stock.

But all the evidence shows that — in recent years — they've
not actually helped boost stock values at all.

They used to be illegal

For most of the stock market's history, buybacks were actually
illegal — considered to be insider trading — the thought being
that if you ran the company, you would have nonpublic information
to know when to buy shares.

This changed in 1982, when the Securities and Exchange Commission
passed rule
10b-18, which, despite a few mechanical restrictions, opened
the gates for companies to begin to repurchase shares en masse.

Buybacks then became a part of the corporate lexicon, and for a
while they did well. Numerous studies found that in the 1990s,
companies that completed buybacks outperformed the broader
market. Soon, buybacks became increasingly popular, crossing the
$100 billion-per-quarter mark in 2006 and taking off after the
recession in 2008-2009.

This use of debt also presents a few new issues for firms doing
repurchases. On the basic level, as Jonathan Glionna at Barclays
noted recently, if it becomes harder to borrow (which appears to
be happening), the spigot that allows the face-saving buybacks
will be shut off.

Analysts have been concerned about the historic size of US
companies' debt for some time, and buybacks are contributing to
this burden — again without doing anything to grow a business or
generate additional cash flow that could help make sure the debt
is paid down.

Think of it in terms of the restaurant: If the restaurateur
had taken a loan to remove the tables, he'd have debt to repay,
but no additional income to pay it with.

Dragan Radovanovic/Business
Insider

Why are companies buying themselves?

There are a two answers to this question — one theoretical, one
practical.

Companies don't want to just sit on money, much for the same
reason that investors don't like holding piles of cash either:
Inflation erodes the value of the cash, so putting it to work
makes sense.

During periods of economic growth, it is better to allocate
profits to capital (like a factory) or labor. This is an
investment in the future of the firm, but it is also risky
because the economy could worsen.

So in periods of economic uncertainty — like right now —
companies choose to give cash to shareholders instead.

"I'm very sympathetic to companies buying back shares," Mike
Thompson, head of S&P Investment Advisory Services, told
Business Insider. "In an environment like this return cash to
shareholders keeps them pleased with the short-term gains while
not committing to large investments that could hurt performance."

Making it all look better

Theoretically that all sounds great, but practically speaking, a
company engages in buybacks because its stock is cheap. For
instance, every time Berkshire Hathaway's share price falls under
a certain level, Warren Buffett said that
he automatically snaps up shares.

Then if the value of the company goes back up, the company can
always reissue the shares and use the gain to fund other
projects. And it simply makes them look good. This use of
buybacks as an image booster has become one of the most divisive
ideas about repurchases, with many analysts and market watchers
calling it "financial engineering."

One of the most tracked measures of a company's performance is
earnings per share. EPS numbers usually are the first thing
investors and the media look for in a business's results — and
whether the number beat expectations set by industry and
sell-side research analysts at financial firms.

Critics of buybacks say they're the easiest way to game the
system and come in above EPS forecasts, thus making a company
look better. Since EPS is generated by dividing profits by shares
in the market, if you shrink the number of shares, the EPS will
rise. One company that has faced scathing criticism over this
issue is
IBM, in particular from billionaire investor Stanley
Druckenmiller.

Andy Kiersz/Business Insider

IBM shows us how it works

IBM spent $4.6 billion in buybacks last year alone,
and
$125 billionin the decade prior, according to
Reuters.

Here's what it has to show for its efforts: In the past
five years, its total share count is down by about one-fifth, and
earnings per share are up 15%.

But actual net income in the same period? Down
11%. Sales have fallen, too.

Druckenmiller, who has been betting against IBM since
2013, cited the buybacks (rather than investment in the business)
as a factor when he first made his case publicly against the
company.

"They should be investing and taking on the challenge of
the Amazons of the world. Instead they're cutting costs, they're
buying back stock so their earnings look good," he told
Bloomberg's Stephanie Ruhle in late 2013. "Very short-term
thinking. When I look out on a couple of years I would think
they've got issues."

“The corporate sector today is stuck in a vicious cycle of
earnings management, questionable allocation of capital, low
productivity, declining margins and growing indebtedness,”
Druckenmiller said in May. “You can only live on your seed corn
so long.”

The meaning for the market

Whatever the reason companies are buying back their own stock, it
is becoming on of the biggest trends of the post-financial-crisis
stock market.

The problem is that the buybacks may not be working. According to
data from FactSet's Andrew Birstingl, the performance of
companies engaging in buybacks has been disappointing.

"In the past year, companies repurchasing shares saw an excess
weighted cumulative return of -1.9% relative to the benchmark,
while companies not repurchasing shares saw a return of 9.8%
relative to the benchmark," Birstingl wrote in his quarterly look
at buybacks.

On a three-year horizon, those companies buying back shares ended
up with a -2.9% return against a gain of 11.5% for those not
doing repurchases. IBM, incidentally, has lost about $50 billion
in market value since the end of 2013, or about 30%.

Additionally, a study by Inmoo Lee of the KAIST College of
Business, Yuen Jung Park of Hallym University, and Neil D.
Pearson of the University of Illinois at Urbana-Champaign found
that companies
that completed buybacks outperformed the benchmark prior to
2001. Firms that completed share repurchases between 2002 and
2006, however, have not generated any better returns since that
time than those who did not.

Based on this research, for both the short- and long-term,
buybacks aren't helping share prices.

However, it is very plausible that in recent years, firms
are more pressured to return cash back to investors who are aware
of the market’s positive reaction to buyback announcements and
want to earn even higher returns after experiencing positive
returns as Carl Icahn pressed Apple to buyback more
shares. Alternatively, it is possible that managers
whose compensation is tightly linked to stock performance become
more aware of buyback’s positive announcement effects in recent
years and use buyback announcements to boost up stock prices for
their own benefits. If these non-fundamental related
motivations drive buyback waves in recent up markets, we would
expect poorer performance of these.

In other words, all those theoretical capital-allocation reasons
mean nothing. It's about image.